Question

2. a) Suppose that, initially, ? = 0%. What would the Fed have to do to get inflation started in the IS-LM/PC model?

b) Then, how would the Fed stabilize the inflation rate after, say, one period?

c) What effect would this have on the nominal interest rate and why?

d) What effect would this have on the velocity of money and why? [Even though the effect might be quite small.]

Answer 1

a) To start inflation Fed can increase money supply. Inflation and money supply are positively related. Increase in money supply shifts LM curve to the right resulting in new equilibrium at e'.

b) Fed can stabilize the inflation rate by stabilising the money supply. By maintaing money supply constant, it will prevent inflation to increase further.

c) At e' interest rate is lower at i'. Interest rate is lowered to encourage people to demand more money as the return on bond is now lower.

d) velocity of money is the rate at which money is exchanged in the economy. With inflation real purchasing power of one dollar falls and people have to pay more dollars now. More money is exchanged now which increases velocity of money.